2016 will be, in Europe, a critical year but not for the reasons we think. A Brexit is unlikely. To gamble with the idea in a poll or at the Commons, in order to show his dissatisfaction is one thing, to risk to destabilize the economy of his country is a different thing. The City relies on the implantation of international banks and a lot of non European enterprises have chosen England as an entry point to Europe. Its deficit financing depends on foreign investors. Electors begin to be aware of these realities. Prime Minister Cameron knows it. But, in exciting that threat, he will have gained concessions from Brussels and succeeded in a smart internal political maneuver.
A resurgence of a crisis in the euro-zone is also unlikely. ECB has now the tools to reduce tensions on the sovereign bonds market and even Greece is now ready to discipline itself. Germany will continue to complain and to rise its voice to warn countries which don’t respect fiscal and budget rules it has imposed during the 2012 crisis. And France will continue to juggle with statistics to explain it will return to a 3% deficit, without ever reaching it. All excuses will be good, including migrant crisis and threats on safety, to postpone the expiry date. With unchanged policies, Europe is condemned to a mediocre growth rate. Conditions are met for people disaffection increase. So, what to do?
The trouble comes from the rules adopted at the foundation of the euro-zone which have been hardened with the euro crisis. They are applied to State members but their weight is so heavy that they affect the whole continent. Instead of asking for “structural reforms” nobody gives precise details about, it would be better to change principles which have demonstrated their inefficacy. Until the 2008 crisis, the two best pupils, according to these rules, were Spain and Ireland and they were those who were the most hardly hit. In focusing on public debts Europeans Treaties authors had just forgotten that there were also private debts. At the opposite, the U.S. and U.K. emerged from the crisis more quickly than the others countries, with budget deficits by far larger than 3% of their GDP.
Economy is different from medicine. Human body doesn’t change and remedies don’t become obsolete in a few years. World, is always changing. Goods, services and capital exchanges are affected as economic agent behaviors. It’s why medicine is a science and economy is not. 2015 world has nothing anymore in common with 1990 world. Those who elaborated the Treaties were taught economy by professors who learnt it in postwar models. The 2007-2008 crisis was not foreseen since its causes were not documented in economic textbooks.
The purpose of the euro-zone rules was to protect against the inflation risk, which haunted Germany due to its past. An independent ECB was supposed, through its policy, to contain prices rising above 2%. In order to avoid that uncontrolled public finances provoke inflation in giving an excessive stimulation to the demand, maximum annual deficit was fixed at 3% of the GDP and public debt at 60%. These rules were the same for each country. They failed to prevent the quasi bankruptcy of the Spanish and Irish banking systems and the Greek slippage whose financial situation had been roughly dissimulated.
The purpose of these rules was then changed. It was not anymore the protection against the inflation risk, but the protection of the “virtuous States” which did not have to pay the mistakes of irresponsible political leaders. These rules were toughened in 2012 for that reason and have now a political character since inflation risk has disappeared. But their enforcement had had heavy consequences with an economic stagnation and an unprecedented unemployment level which contribute to people disaffection toward the European project through every election.
ECB now has fixed, as a target, to push up prices to an inflation rate close to 2%. The world has turned upside down. It will not achieve its goal : competition between companies, productivity gains thanks to innovation and raw materials abundance push prices toward stability or even down. Money supply rise is powerless. Japan experimented that during twenty years without any result. In return, these policies might provoke turbulences on financial markets which are not without negative consequences.
The last tool governments had after the 2009 Great Recession was the use of public expenditures. European rules have limited its range. To cope with the negative effects of this situation, ECB launched its quantitative easing program without success. The euro-zone became, with Japan, the laggard of the world economy. To come back to budget equilibrium in a deflationary context is almost impossible, except if you have very special characteristics. Stagnation has a heavier impact on fiscal receipts than the contribution of expenditures restrictions.
These requirements are especially subject to criticism since there is no global risk generated by public finance disequilibrium. The euro-zone enjoys a huge current account surplus and it doesn’t rely on foreign money to finance it. The two most important countries which have been constrained by budget restrictions, France and Italy, have households financial saving rates large enough to finance their own public deficits. These rules are also inappropriate since countries characteristics, demography but also diplomatic engagements with the resulting military expenses, are very different from one country to another. It is easy to look virtuous when your birth rate is so low that population is decreasing as, in the same time, the most important source of public expenditure, education. We can say the same thing about defense spending. The difference between France and Germany is about 1% of their GDP each year. This explains the 20% gap between their respective public debt ratio.
Financial rules which regulate the euro-zone must be softened if we want a growth rebound in Europe. Germany, with its traditional allies, Holland and Finland, will oppose it. But it is not sure they can stick to this hard line during a long period since it is against their interest. European stagnation and emerging countries problems will weight on their industries. The threat is mounting on their retirement system which relies on the revenues of their pension funds. The persistence of very low interest rates will shortly put them into a heavy deficit.
Opposite budget and monetary policies cannot coexist forever. So, why wait for? The only answer is to review budget requirements and to adapt them in taking account of the structural differences between countries. The survival of the European project is at stake.